Money, growth, and risk sharing with private information

Abstract

This paper examines the implications of incomplete risk-sharing for endogenous growth and welfare in a monetary economy. The market incompleteness comes from private information on idiosyncratic productivity shocks faced by individual consumers. Inflation tends to reduce the rate of growth and welfare. In the private information setting, higher capital stock increases the gains from misrepresentation of the realized productivity shock. The incentive-compatibility then requires larger variations in lifetime consumption, yielding lower welfare to consumers who are risk averse. As the inflation rate rises, money is used less for insurance purposes, causing consumers to be more vulnerable to consumption risk. Additional capital causes consumption to be even more variable, and therefore consumers shift away from capital investment in the inflationary economy. As consumers have more limited access to the financial intermediary, the growth-reducing effects of inflation increase and the welfare cost of inflation becomes substantially greater.